Fundraising Success: How The Revenue Multiple Factors In A Company Valuation

Company owners, investors, and analysts use different methods and tools to value startups, and the revenue multiple is one of them. Evaluating a startup accurately can make the ultimate difference in successful fundraising efforts or a strategic M&A deal.

The revenue multiple tool is fast-catching on among analysts since it is simple to calculate and offers effective results. This metric is particularly helpful in evaluating startups that haven’t added up impressive sales and profits. And have yet to realize their full potential.

Typical valuation strategies don’t really apply to fledgling companies such as financials, a dedicated customer base, or EBITDA. The startup is not old enough to have an extensive track record or a proven product portfolio. This is why investors must rely on other metrics to determine its viability.

That’s where the revenue multiple comes in. Read ahead to understand in detail how to calculate this metric and how it can influence your fundraising efforts. Or even the asking price you can command if you choose to exit the company with a strategic sale.

Calculation Techniques for the Revenue Multiple

The revenue multiple is proving to be pivotal to the startup ecosystem and is simply expressed as the company’s value relative to its revenue. You’ll divide the company’s total value or the market value of its equity by revenue over the last 12 months.

The resultant number indicates its market position and potential for growth. Investors and founders can use this metric to evaluate the startup by comparing it against other companies within the sector. That’s how they can make strategic decisions for funding and viability.

Let’s try this example. The equity price of ABC company is $6M, and it earns an annual revenue of $1.5M. Using the revenue multiple calculation, we calculate 6,000,000 (selling price) divided by 1,500,000 (annual revenue).

We arrive at the multiple: 4x. Next, similar calculations are performed on five companies within the same sector, and an average multiple of 3.25x is obtained.

Using this figure, we can calculate the value of the targeted startup, PQR company. If its annual revenue is $2M, its estimated valuation is 2,000,000 (annual revenue) x 3.25 (average multiple) = 6,500,000.

Investors can now have a fairly accurate valuation figure to rely on when investing in the company.

Why Investors Prefer the Revenue Multiple

Startups that have yet to generate profits typically base their value on financial projections, industry trends, and overall market analysis.

Including the revenue multiples in the final metric provides a more balanced and accurate analysis. That’s because it factors in the company’s performance over an extended interval as well.

Ultimately, the crux is whether or not the company can generate a positive and high amount of cash flow. And whether that cash flow is consistent over at least the last 12 months.

This factor is crucial, particularly in the case of startups in new and upcoming verticals and the tech sector, for example.

If the core product is disruptive, investors would want to be sure that the concept is robust enough. Consistent revenues indicate that the product has value and is building a customer base. Projections alone can be ineffectual in accurately predicting if the company can create the desired impact.

Investors need not rely on estimates and rules of thumb to evaluate the startup’s viability. Focusing on the revenue multiple is always a better option.

Advantages of Using Revenue Multiples in Estimating Startup Value

As explained above, the revenue multiple metric is an effective strategy for estimating a startup’s value, which is still new. Since it has yet to demonstrate profitability, analysts can estimate whether it is worth backing.

Leveling the Playing Field

The revenue multiple is also helpful when evaluating startups in verticals like legal, consultancies, medical offices, and accounting. With all other variables being equal, startups that have a low revenue multiples are less likely to attract capital. That is, in comparison to companies with a higher multiple.

Using the revenue multiple levels the playing field and places all companies on an equal standing. Their maturity levels and scale are no longer pertinent. That’s because the revenue multiple becomes a benchmark for evaluating companies within the vertical.

Focusing only on the revenues or only on the book value or equity value is not a practical valuation strategy. These metrics can become negative for newly established or faltering companies.

However, the revenue multiple offers a more comprehensive overview by factoring in industry averages, equity values, and revenues. Viable startups that would have been passed over by investors still stand a fair chance at getting backing and capital.

Keep in mind that, in fundraising, storytelling is everything. In this regard, for a winning pitch deck to help you here, take a look at the template created by Silicon Valley legend, Peter Thiel (see it here), which I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.

Remember to unlock the pitch deck template that is being used by founders around the world to raise millions below.

Multiples of Revenues Eliminate Variable Costs and Market Conditions

When calculating the book value or net and gross profits, accountants may factor in R&D costs and inventory purchases.

They’ll also deduct depreciation, overheads, and any other expenses to arrive at net figures. But, revenues are the actual earnings the company earns and cannot be manipulated.

Most importantly, varying costs from month to month cannot influence the revenue multiple but do affect the earnings or profit multiple. That’s because the final calculations must account for the Earnings Before Interest, Taxes, Depreciation, and Amortization.

Macro and microeconomic factors can affect profits and the price-to-earnings ratios but not the price-to-sales ratios.

Making Sound Investment Decisions

The revenue multiple allows investors to leverage comparative analysis and industry benchmarks. These actual ratios and concrete metrics are far more reliable than financial projections and growth models. The figures obtained from these models are reliant on speculation and estimations.

Investors need not focus on what’s possible and can happen but can base their decisions on what’s happening now. They can disregard the hype created around upcoming industries and disruptions. And focus on product categories that have already captured customer interest.

Simplifying Valuation

The revenue multiple valuation technique is possibly the simplest and least complex method of evaluating upcoming startups. Specifically for new ventures that are scaling rapidly and have the potential for even further accelerated growth.

Using this metric, investors can accurately evaluate companies that don’t have adequate financial data in their pitch decks. Not just investors but founders can also use this tool to value their ventures.

Budding and seasoned entrepreneurs and investors can quickly estimate value without the need for complicated tools and expert analysts.

The revenue multiple is just one of the many valuation techniques you can use to assess startups. Ready for more options for how to value your company? Check out this video I created.

Downsides of Using Revenue Multiples to Assess Startups

Although using the revenue multiple technique has multiple advantages, it also comes with a set of cons. Disregarding crucial metrics and factors can often lead to miscalculations and false estimates that can prove to be disastrous. For both–investors and entrepreneurs.

To begin with, this method accounts only for the actual revenues the company earns. However, it does not factor in the debt the startup may have accrued and its lack of operational efficiency. Then again, it could incur high expenses, which would take away from the net profits it earns.

For instance, in the case of sectors that are capital intensive, such as agro-based industries, Startups must invest substantial capital at the onset to initiate research and development.

At this point, they cannot be sure of whether the investment will yield value or innovations. Or that the innovation can eventually be converted into a market-ready product.

Even before the venture started to generate revenues, it could have added up significant costs and owed interest to investors. Factors like this can bring down its value significantly, and the multiple will not account for this situation.

While high revenues are a great metric, analysts must also factor in adequate cash flow cycles for stability and sustainability.

Without it, the company might not be able to stay in business long enough for the investment to generate returns. If the startup’s financials indicate negative earnings, profit margins, and book value, the revenue multiple metrics could be misleading.

The particular industry under consideration is also an underlying factor. Each sector has different dynamics and variables, and applying the multiple of revenue may not work for all startups across the board.

For instance, the tech industry typically has high multiples. Tech and software startups will, thus, have a higher growth potential than other industries.

Additional Factors to Consider When Estimating the Revenue Multiple

The revenue multiple is, undoubtedly, the least complex and easiest to compute evaluation metric. However, several other factors also come into play here. Without considering these nuances, interpreting and applying the multiple can be misleading.

Macroeconomic and Vertical-Specific Conditions

Analysts must account for the macroeconomic and vertical-specific conditions that influence the metric. These conditions include industry and market trends, the startup’s estimated growth, and internal operations.

Regardless of its high revenues, startups cannot work in a vacuum. They are a part of the broader industry where they operate. As a result, its overall stability and growth trajectory will certainly affect the startup’s individual success and failure.

Let’s take, for example, a life sciences and medicine company that invests in IP to develop innovative diagnostic equipment and medicines. Having acquired licensing and compliance certificates, it can continue marketing products indefinitely.

This sector has assured growth rates and scalability, which means that its benchmarks will be specific to the startup in question.

Overall Market Sentiment

Similarly, if the market undercurrents are positive, investors will be optimistic and open to backing startups.

The pandemic was a good example of when companies developing vaccines, medicines, and testing equipment were in high demand. Their potential to capture a higher market share made them attractive to investors.

On the other hand, the pandemic also slowed the growth of the tourism and hospitality industry. As long as the future was uncertain and lockdowns were in progress, bookings were canceled, and travel took a nosedive. The higher risk aversion stalled investment as investors scaled back activities.

Startup-Specific Conditions

Taking a comprehensive overview of the startup is a crucial factor in estimating its value. Each venture is unique with respect to its business model, product-market fit, product portfolio, and talent. Valuation must also factor in its market share, customer acquisition costs, and customer churn rates.

The management team and founder’s success rates and track record also come under scrutiny when investors assess ventures. If all these variables are positive, the startup has the potential for accelerated growth. Even if the revenue multiple is not impressive as yet, the startup could attract investor interest and funding.

The Takeaway – Is the Revenue Multiple Reliable?

The revenue multiple is, undoubtedly, an effective technique for conducting a comparative analysis for a fledgling company. Since it factors in industry averages and the company’s revenues over an extended interval, it can be a reliable metric.

The multiple is fairly easy and straightforward to calculate a new startup’s potential. That is, even if it has yet to generate profits. At the same time, investors, founders, and analysts must acknowledge its downsides.

Relying on the multiple as a standalone metric is radically misleading since it doesn’t consider several other relevant factors. The company’s internal dynamics and external industry-specific conditions also influence performance since it cannot function as a standalone entity.

When calculating revenue multiples, analysts must account for market trends, changing customer buying preferences, and the rapidly evolving nature of the vertical’s ecosystem. These factors are also under careful scrutiny from investors since they are looking for robust concepts to back.

Adopting a more balanced approach is advisable when valuing a venture as a viable investment opportunity. Taking a comprehensive and realistic overview of the available financial data ensures a more accurate evaluation of the startup’s potential.

That’s how investors, founders, and analysts can be confident of their findings when valuing ventures.

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